Saturday, August 6, 2011

Arbitrarily Negative Interest Rates

One of the most common objects to a gold standard (or any deflationary currency scheme) is the Keynsian one - that prices (particularly wages) are sticky and that a deflationary currency is the cause of fundamental structural problems that will eventually be the downfall of said currency.

For the record, I don't actually think that the problems with wage stickiness are that pronounced. People simply don't have enough experience with a solid gold standard (as opposed to a slowly devalued one) to really say one way or another.

That being, said, it would be quite easy for a sovereign to neutralize this objection. For just how to do this, we have to travel back in time to the 1990's in Brazil. At the time Brazil was undergoing mild hyperinflation (1200%/year). The government was unable to stabilize its currency through traditional means, and turned to a number of academics who proposed a novel solution, which Brazil successfully implemented.

The first part of the solution was to create a virtual currency, pegged to the US Dollar. Prices had to be quoted in the virtual currency, but payment had to be made with the actual currency. After some time, the Brazilian government transitioned everyone to a new currency that had 1:1 parity with the virtual currency, ending the hyper-inflation.

In an economy with a fixed quantity of money, the general price level declines in rough proportion to the increase in productivity. In order to neutralize this, one could simply require everyone to quote all prices in a virtual currency which is then decreased in value in proportion to the increase in the general price level. Viola - constant value pricing.

One can go even further though. During the last couple economic crises, the press was filled with stories of liquidity traps - a situation wherein the interest rate could not be lowered sufficiently to stimulate economic activity. With a virtual currency, this is not a problem at all. The currency itself can be debased to an arbitrary extent. As long as all prices above some meaningful threshold have to be quoted in the virtual currency, there should be no problems.

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